In this video we will talk about ETFs, what they are, their types, how to evaluate them and how to invest in them.
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An ETF or exchange-traded fund (ETF) is a type of pooled investment security that you can buy or sell through a brokerage firm or stock exchange the same way that a regular stock can
Typically, ETFs will track a particular index, sector, commodity, or other assets. In a previous video we have talked about stocks sectors, and we have seen their respective ETFs.
Basically each sector has its own ETFs, you have a Utilities ETF, Materials ETF, Information Technology ETF and so on.
ETFs began in 1993 with the product commonly known by its ticker symbol, SPY, or “Spiders,” which became the highest volume ETF in history. Today,, ETFs are estimated at 6.64 trillion dollars with nearly 3,000 ETF products traded on US stock exchanges.
You are probably wondering how an ETF is working:
Well, An ETF is bought and sold like a company stock during the day when the stock exchanges are open. Just like a stock, an ETF has a ticker symbol and intraday price data can be easily obtained during the course of the trading day.
For example let’s have a look at a popular stock Market ETF, the QQQs. The Invesco QQQ ETF, formerly known as the PowerShares ETF, is an exchange-traded fund that tracks the Nasdaq 100 index. The QQQ is widely considered to be one of the safer ETFs on the market and has received positive performance rankings from analysts. But let’s have a look at it in trading view. ETFs are like stocks in essence, you can see the price, currently trading at 275$, the chart, it has been traded for the past 20 years, and in general you can do some technical analysis like on any other stocks.
However, Unlike a company stock, the number of shares outstanding of an ETF can change daily because of the continuous creation of new shares and the redemption of existing shares. The ability of an ETF to issue and redeem shares on an ongoing basis keeps the market price of ETFs in line with their underlying securities.
Although designed for individual investors, institutional investors play a key role in maintaining the liquidity and tracking integrity of the ETF through the purchase and sale of creation units, which are large blocks of ETF shares that can be exchanged for baskets of the underlying securities. When the price of the ETF deviates from the underlying asset value, institutions utilize the arbitrage mechanism afforded by creation units to bring the ETF price back into line with the underlying asset value.
Now that you know what an ETF is and how it works let’s talk about the advantages of purchasing an ETF:
First Diversification, One ETF can give exposure to a group of equities, market segments, or styles. An ETF can track a broader range of stocks, or even attempt to mimic the returns of a country or a group of countries. Think of QQQs, it tracks the Nasdaq 100, or the ETFs that track an entire sector.
Second as we mentioned earlier it trades like a stock. Although the ETF might give the holder the benefits of diversification, it has the trading liquidity of equity.
To be more specific, ETFs:
- Can be purchased on margin and sold short.
- They can trade at a price that is updated throughout the day.
- They also allow you to manage risk by trading futures and options just like a stock.Because ETFs trade like a stock, you can quickly look up the approximate daily price change using its ticker symbol and compare it to its indexed sector or commodity like we did earlier with the QQQ.
Third, Lower Fees. ETFs, which are passively managed, have much lower expense ratios compared to actively managed funds, which mutual funds tend to be. What drives up a mutual fund’s expense ratio? Costs such as a management fee, shareholder accounting expenses at the fund level, service fees like marketing, paying a board of directors, and load fees for sale and distribution.
Fourth, Limited Capital Gains Tax. ETFs can be more tax-efficient than mutual funds. As passively managed portfolios, ETFs tend to realize fewer capital gains than actively managed mutual funds.
Fifth and last, Lower Discount or Premium in Price.
There is a lower chance of ETF share prices being higher or lower than their actual value. ETFs trade throughout the day at a price close to the price of the underlying securities, so if the price is significantly higher or lower than the net asset value, arbitrage will bring the price back in line. Unlike closed-end index funds, ETFs trade based on supply and demand, and market makers will capture price discrepancy profits.
Despite all their advantages, like every other investment type they have disadvantages as well.
- Trading fees
Although ETFs generally have lower costs compared to some other investments, such as mutual funds, they’re not free. ETFs are traded on an exchange like a stock, so investors may have to pay a real or virtual broker to facilitate the trade. These fees typically range from $8 to $30, and they’re paid every time the investor buys or sells shares in a fund. - Operating expenses
Although most ETFs are passively managed, fund managers still incur expenses as part of normal business operations. These costs are reflected in the fund’s expense ratio, which measures the percentage of an individual’s investment that will be paid to the fund each year. As of today, ETF expense ratios were usually less than 0.5%. - Low trading volume
When an ETF is actively managed, the higher number of trades within the fund may make the price more predictable. High trading volume can also make the ETF more liquid, which can be beneficial. However, most ETF trading volume is low, so the bid-ask spread may be wider, meaning investors might not get the price they expected. Investors can check an ETF’s average trading volume before purchasing the fund to see whether it will meet their needs. - Potentially less diversification
Many ETFs offer diversification because they contain hundreds or even thousands of securities within and across asset classes. But some ETFs are narrowly focused, concentrating on a particular sector of the market or a subset of an asset class. For instance, some funds focus on large-cap or small-cap stocks, a particular country, a specific industry, or a particular commodity. - Capital gains distributions
Some ETFs own dividend-paying stocks, which generate cash. On other occasions, an ETF might sell an asset at a profit that results in capital gains. The fund manager can distribute this money in two ways: pass the cash to the investors or reinvest it into the ETF’s underlying securities. Investors who receive cash but want to reinvest the money will need to buy more ETF shares, which creates new fees. No matter how the ETF uses this cash or its source, shareholders are responsible for paying taxes. Every ETF treats dividends and capital gains distributions differently, so investors will need to research the fund’s policy before investing in it. - ETFs are designed to track indexes, sectors, commodities, or other assets. But many track a benchmarking index, which means the fund often won’t STO the underlying assets in the index. Investors who are looking to beat the market may choose to look at other products and services.
Now that you know both the good and the bad side of ETFs let’s proceed and have a brief look at the different types of ETFs in the market.
Those are:
1. Stock ETFs
Stock ETFs (also known as equity ETFs) track major stock market indexes such as the S&P 500, Dow Jones Industrial Average, and Nasdaq.The oldest, largest and most popular ETF in the world is the SPDR S&P 500 ETF, which trades under the symbol SPY. SPY tracks the S&P 500 index. This simply means the ETF owns all of the stocks included in the S&P 500.
Index ETFs are perfect for investors because they give your portfolio exposure to a wide range of stocks with a single purchase.
2. Sector and industry ETFs
Sector and industry ETFs allow you to diversify your portfolio with stocks across multiple sectors and industries. For Example: Utilities, Healthcare, Materials and so on.
3. Commodity ETFs
A commodity ETF tracks specific commodities. A commodity is a raw material or agricultural product that can be bought and sold. Examples of a commodity include gold, oil, coffee, wheat, rice, or livestock. When you purchase a commodity ETF, you do not own the underlying commodity itself. For example, if you bought a gold ETF, you are investing in gold, but you don’t get a physical gold bar.Instead, you are purchasing a derivative contract that follows the price of gold. A derivative contract essentially allows you to invest in a commodity, such as gold, without setting up a gold mine in your backyard.
4. Style ETFs
Style ETFs track a specific investment style, asset class size, or asset class style. An investment style is a set of guidelines used to build your investment portfolio. For example, it’s not uncommon to see investment styles categorized by risk tolerance.Risk tolerance refers to how much you are willing to risk to grow your portfolio. Investment styles can also be categorized by the type or size of stock. For example growth stocks versus value stocks, or Large cap stocks vs Mid cap or small cap.
5. Bond ETFs
A bond ETF is a type of ETF that invests in bonds. We talked in detail about Bonds in a previous video,so if you have watched it you would know all about them. Anyhow a bond ETF is not subject to maturity because they trade on the stock market. This means you can buy and sell them throughout the day, just like stocks. Plus, you will be able to benefit from interest payments.
6. Inverse ETFs
Also known as short ETFs and bear ETFs, an inverse ETF seeks to capitalize from the declining price of a stock or other investment. Quite popular at the moment, as it is an ebay way to short the market.
An inverse ETF is basically shorting the market, as it bets against it. Instead of shorting stocks, the ETF bets on the direction of a stock price using futures contracts.
7. Actively managed ETFs
Actively managed ETFs combine the benefits of a mutual fund with an exchange-traded fund (ETF). A mutual fund is almost identical to an ETF in that it’s a fund that holds a basket of individual investments. Where a mutual fund starts to differ is that it’s actively managed by a manager who makes decisions on how to invest the fund’s money. ETFs do not have a manager. That is until now.
Actively managed ETFs give you the flexibility to buy and sell shares of the ETF on the stock market. But unlike most ETFs, an actively managed ETF does have a management team that makes investment decisions.
8. Dividend ETFs
Dividend ETFs are ETFs made up of dividend-paying stocks. Shares of a dividend stock come from companies that make regular quarterly payments to shareholders. These payments are taken from the company’s profits. A dividend ETF not only offers you a regular income from dividends, but it also adds instant diversification to your portfolio. Unlike investing in individual dividend stocks, a dividend ETF offers a straightforward solution to getting exposure to multiple dividend stocks all in one.
9. Real estate ETFs
Real estate ETFs aim to track the performance of the real estate sector. When you purchase a real estate ETF, you don’t actually own any physical real estate. Instead, real estate ETFs contain REITs.
REIT stands for real estate investment trust. A REIT allows you to invest in real estate without all the work typically involved with building and managing physical properties. In other words, you get the benefits of real estate investing without all the headaches.
REITs are also required by law to payout at least 90% of its taxable income each year in the form of dividends. Similar to dividend stocks, REITs can give you consistent passive income. Like any ETF, real estate ETFs give your portfolio instant diversification because they invest in a bundle of REITs instead of just one or two.
10. Currency ETFs
Currency ETFs are built with the goal of providing you exposure to the foreign exchange market (forex).A currency ETF allows you to diversify your portfolio by investing in currencies without the hassle of placing individual trades on the forex market, which can be quite confusing for most.
11. Foreign market index ETFs
Foreign market index ETFs allow you to invest in international stock market indexes. If you wish to further diversify your portfolio with companies outside of the U.S.
Also I would like to mention 5 key factors to consider prior investing in an ETF. Those are:
First, Level of Assets: To be considered a viable investment choice, an ETF should have a minimum level of assets, a common threshold being at least $10 million. An ETF with assets below this threshold is likely to have a limited degree of investor interest. As with a stock, limited investor interest translates into poor liquidity and wide spreads.
Second, Trading Activity: An investor needs to check if the ETF that is being considered trades in sufficient volume on a daily basis. Trading volume in the most popular ETFs runs into millions of shares daily. Some ETFs barely trade at all. Trading volume is an excellent indicator of liquidity, regardless of the asset class. Generally speaking, the higher the trading volume for an ETF, the more liquid it is likely to be and the tighter the bid-ask spread. These are especially important considerations when it is time to exit the ETF.
Third, Underlying Index or Asset: Consider the underlying index or asset class on which the ETF is based. From the point of view of diversification, it may be preferable to invest in an ETF that is based on a broad, widely followed index rather than an obscure index that has a narrow industry or geographic focus.
Fourth, Tracking Error: While most ETFs track their underlying indexes closely, some do not track them as closely as they should. All else being equal, an ETF with minimal tracking error is preferable to one with a greater degree of error.
Fifth, Market Position: The first ETF issuer for a particular sector has a decent probability of garnering the lion’s share of assets before others jump on the bandwagon. It is prudent to avoid ETFs that are mere imitations of an original idea, because they may not differentiate themselves from their rivals and attract investors’ assets.
ETFs are considered the best choice For beginner investors. Index funds are cheaper than their actively managed counterparts, and the reality is that most actively managed funds don’t beat their benchmark index over time.
To invest in an ETF you need to open an account with a broker. All the brokers that allow you to buy and sell stocks will give you the possibility to buy and sell ETFs. Some of those brokers are : Etrade, TD Ameritrade, Fidelity, Charles Swab and Ally Invest.
Also watch: Mutual Funds Explained, What Are Bonds And How Do They Work?, and How To Evaluate A Stock – 5 Important Parts
